Defying Expectations, Japan’s Economy Falls Into Recession

The Shiodome business district in Tokyo. Japan’s gross domestic product fell by an annualized pace of 1.6 percent last quarter, threatening a planned tax increase.CreditCreditThomas Peter/Reuters

By Jonathan Soble

Nov. 16, 2014

TOKYO — Japan’s economy unexpectedly fell into recession in the third quarter, a painful slump that called into question efforts by Prime Minister Shinzo Abe to pull the country out of nearly two decades of deflation.

The second consecutive quarterly decline in gross domestic product could upend Japan’s political landscape. Mr. Abe is considering dissolving Parliament and calling fresh elections, people close to him say, and Monday’s economic report is seen as critical to his decision, which is widely expected to come this week.

“Unfortunately, the numbers were not good,” Mr. Abe said in a speech at an event hosted by the Komeito party, the coalition partner of his governing Liberal Democratic Party. "Now that we’ve finally grasped the chance to escape from our long deflation, we cannot let it get away.”

Rising sales taxes have been blamed for triggering the downturn by deterring consumer spending, and with Japan having now slipped into a technical recession, the chances that Mr. Abe will seek a new mandate from voters to alter the government’s tax program appear to have increased significantly.

The preliminary economic report, issued by the Cabinet Office, showed that gross domestic product fell at an annualized pace of 1.6 percent in the quarter through September. That added to the previous quarter’s much larger decline, which the government now puts at 7.3 percent, a slightly worse figure than in its last estimate of 7.1 percent.

The surprise recession underscores the difficulties faced by Mr. Abe, who won power two years ago on a pledge to reinvigorate the economy and end his country’s long streak of wage and consumer-price declines. His agenda, dubbed Abenomics, has focused largely on stimulus measures, in particular an expanded program of asset purchases by the central bank. Yet its impact, economists say, has been dulled by the tax increase, which was approved under a previous government.

The tax plan was intended to curb Japan’s immense government debt, which at about two and a half years’ national economic output is the largest in the developed world. But there are concerns that after years of sluggish wage growth, consumer confidence is still too weak to handle the increase. Instead of solving the debt problem, heavier taxes could simply push the economy back into a downward slide.

“Raising the consumption tax is supposed to increase government revenues, but if we fall back into deflation it will all be for nothing,” Mr. Abe said at a meeting of Group of 20 leaders in Brisbane, Australia, on Sunday.

Akira Amari, Mr. Abe’s economy minister, said after the economic report on Monday that rising taxes were having “a larger impact than expected, given that Japan’s deflationary mind-set has not yet been cleared away.”

The still half-completed sales-tax increase, a heated political issue in Japan, has also become a target of concern for leaders in the United States. Last week Treasury Secretary Jacob J. Lew urged Japanese and European policy makers to do more to stimulate their economies.

“If things are really bad in Europe and Japan, if there’s a real slowdown in China, that’s a headwind in the United States that we don’t need,” Mr. Lew said.

Japan’s economy was already clearly struggling to shake off the effects of the first stage in the planned two-step tax increase, which was implemented in April. After the sharp slowdown in the second quarter, institutions, including the International Monetary Fund and the Bank of Japan, cut their estimates for economic growth this year and next. The central bank, its goal of reaching 2 percent stable inflation looking increasingly out of reach, was prompted late last month to expand its bond-buying program further.

Even so, the data reported on Monday confounded analysts’ forecasts, which were mostly more optimistic. Economists surveyed by news agencies and research groups had been forecasting annual growth of slightly more than 2 percent on average. The report showed weakness in many important areas of the economy. Consumer spending barely picked up from its depressed level after the first tax increase in April, while indicators of housing and business investment declined.

Companies also reduced inventories of finished goods more aggressively than anticipated. That hurt growth but could help the economy rebound later on, since businesses would have to produce more to meet any increase in demand.

The Nikkei 225 stock average fell about 3 percent and the yen weakened against the dollar. European markets were trading slightly higher in their early afternoon on Monday.

Although the second part of the tax increase would not be carried out until October, Mr. Abe needs to decide what to do about it soon, to give Parliament time to change legislation if he opts to cancel or postpone it. If fully enacted, the plan would increase the tax on all goods and services sold in the country to 10 percent over 18 months. It now stands at 8 percent after the first increase in April.

Mr. Abe has not said how much the economy would have needed to grow to give him the confidence to raise taxes again, but one of his economic advisers, Etsuro Honda, has argued that the minimum number needed to be close to 4 percent — higher even than the forecasts and far better than the surprising negative result.

Abenomics is now in a particularly delicate phase. Consumer prices are rising, if not yet as strongly as hoped, as are corporate profits and the value of assets like stocks and property. But so far not much of the new wealth has reached average workers. Incomes have fallen behind the rising cost of living, in effect making people poorer. Another of Mr. Abe’s advisers, Kozo Yamamoto, a veteran lawmaker in the Liberal Democratic Party, says the second tax increase needs to be put off “until wages catch up” to prices.

Mr. Abe and his inner circle appear to have interpreted the economy’s struggles as signaling the need for an even bolder, purer stimulus program. Instead of encouraging economic activity through central bank money printing, on the one hand, while constraining it with higher consumer taxes on the other, he seems poised to twist the policy dial fully toward stimulus.

Many of his critics, however, would like to see him act more assertively in other areas, like loosening business regulations, that they think will have more lasting benefits for the economy.

“The numbers are much worse than expected,” Yukio Edano, secretary general of the opposition Democratic Party of Japan, said. “The boom and bust in demand around the consumption tax hike show the limits of Abenomics.”

Mr. Abe does not technically need to call an election to modify the tax plan, because his party is in firm control of both houses of the national legislature, the Diet. Even the existing tax legislation gives him some scope for review if he judges that the economy is struggling, and with a parliamentary majority, the Liberal Democratic Party and Komeito could rewrite the law as they wanted.

Experts said Mr. Abe might wish to seek a broader mandate for such a controversial issue, however.

“The cabinet will rationally dissolve the Lower House with an aim to seek the public support for the postponement,” analysts at Credit Suisse wrote in a note to clients. “P.M. Abe may decide on dissolving the Lower House by the end of this week.” The Yomiuri newspaper said an announcement could come on Tuesday.

Parliament’s current term lasts until mid-2016, making any election a year and a half sooner than legally necessary. Some political commentators have suggested the tax issue is a convenient pretext for Mr. Abe to seek a fresh term while he has political advantage on his side. Opposition parties are weak and disorganized, and although his once-sky-high poll ratings have slipped, he remains relatively popular, with public support of around 50 percent.

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